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Case Study No. 2
Adam Smith and the Natural Price
Adam Smith explained how economic profits and losses in a competitive market cause the entry and exit
of firms. Smith described what he called the natural price, or the long-run equilibrium price, in this
passage from his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations:
When the price of any commodity is . . . sufficient to pay the rent of land, the wages of labour,
and the profits of the stock employed in . . . bringing it to market, the commodity is then sold
for . . . its natural price . . . .
The commodity is then sold precisely for what it is worth, or for what it really costs the person
who brings it to market; for though in common language what is called the prime cost of any
commodity does not comprehend the profit of the person who is to sell it . . .
The natural price . . . is . . . the central price, to which the prices of all commodities are
continually gravitating . . .
When by an increase in . . . demand, the market price of some commodity . . . [rises above] the
natural price . . . [producers of the commodity] are generally careful to conceal this change. If
it were commonly known, their great profit would tempt so many rivals . . . the market price
would soon be reduced to the natural price . . . . Secrets of this kind, however . . . can seldom
be long kept; and the extraordinary profit can last little longer than they are
kept . . .
The market price . . . can seldom continue long below its natural price . . . the persons affected
would immediately feel the loss, and [some producers] would immediately withdraw . . . the
quantity brought to the market would soon be no more than sufficient to supply the effectual
demand. Its market price, therefore, would soon rise to the natural price.
Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Book One, Chapter VII.
1) What did Smith mean by the “prime cost” of a commodity?
2) How did Smith explain how the entry of firms in a perfectly competitive market ensures that
firms earn zero economic profit in the long run?
3) How did Smith explain how the exit of some firms occurs in a perfectly competitive market to
ensure that firms remaining in the market earn zero economic profit in the long run?
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